Planning for the Worst

Sam Swift

Oct 29, 2018

There’s a new paper out by Eugene Fama and Kenneth French (the academics who are at the heart of our investment philosophy) that argues the industry is underestimating the potential for long-term negative returns in the stock market. Using a statistical technique called bootstrapping, they analyzed monthly returns of the stock market vs. monthly returns of risk-free T-bills to generate 100,000 potential futures. If you are a client of TCI, you may recognize this as similar to what we do in your long-term cash flow planning meeting where we generate thousands of future scenarios to determine your chances of success given different variables.

In short, Fama and French found that it is far more likely that stocks could have negative returns relative to T-bills over longer time periods than most of us probably think. They estimate a roughly 23% chance that stocks could be negative over five-year time horizons and a 15% chance that stocks could be negative over ten-year time horizons. That’s far more than we’ve actually experienced historically.

Furthermore, they dove into their original work on the small and value premiums within the market and found that there was a significant chance that those premiums could be negative over ten-year time horizons (22% chance for small and 9% chance for value). This is despite the fact that they still have higher expected returns on average.

So what is a disciplined investor supposed to do?

First, one can diversify amongst the premiums to give the best chance of long-term success. Ken French elaborated on this paper in a talk that I recently attended. He looked at five expected return premiums (market, small, value, profitability, and quality) and looked at the results for each over ten-year periods. Though it turns out there is a decent chance that at least one of those premiums is negative in any random ten-year period, it is also extremely likely that three or four of those premiums will be positive. For example, even in a period when the market is negative relative to T-bills, it’s likely that an investor could still come out ahead by having a portfolio tilted towards the other factors. We don’t know which of the factors will come out ahead in any period beforehand, but by incorporating them all into a portfolio we can give ourselves the best chance of success.

Second, one can follow a disciplined rebalance strategy. Even in the case where market returns are negative relative to T-bills, there will still be significant volatility on a month-to-month and year-to-year basis. By selling assets that have performed relatively well and buying assets that have performed relatively poorly (rebalancing, in other words) an investor can still grow their portfolio.

Finally, and most importantly, an investor can focus on what they can control to make sure they still accomplish their goals even if the market doesn’t cooperate. The real lesson of Fama and French’s paper is twofold:

  1. We should prepare ourselves that bad periods in the market are more likely to happen than we realize; and
  2. If those bad periods do materialize, we can only truly solve them by controlling how much we spend, when we retire, and how much we save.

This is why we are constantly checking in on the question with our clients, “Am I okay?” We can’t do much to generate positive returns in a market that’s unwilling to give them, but we can help a client adjust their individual plan to maximize their goals within the context of the market reality that they find themselves in.

Spend 20 minutes with us.

Every client journey begins with a conversation. To discover whether TCI is a good fit for your financial planning needs, call us to schedule a quick, completely free, low-risk call with an advisor. It’s that easy, seriously!

(877) 733-1859

Your Name

Phone Number

Email Address